SWF Real Estate v. Comm'r—Special Allocation of Tax Credit Generated by Conservation Easement Donation was Disguised Sale, but Easement Valuation Largely Upheld

In SWF Real Estate, LLC v. Comm'r, T.C. Memo. 2015-63, the Tax Court held that a partnership’s transfer to a 1% partner of 92% of the state tax credit generated by the partnership’s charitable contribution of a conservation easement was a taxable disguised sale under IRC § 707. The court also determined, however, that the partnership had only minimally overstated the value of the easement for federal deduction purposes.

Background

In May 2001, John L. Lewis IV purchased a 674.65 acre parcel in Albemarle County, Virginia (Sherwood Farms), through his wholly-owned S-corporation. The S-Corporation then contributed the farm to SWF Real Estate, LLC (SWF), in exchange for 100% of the membership interests in SWF.

Virginia is one of several states that encourages donations of conservation easements within its borders by giving donors transferable state income tax credits in an amount equal to a percentage of the value of the donated easements. The credits can be used to offset the donors' state income tax liability, dollar for dollar, for a period of years, and excess credits can be sold to other Virginia taxpayers to be used to offset their state income tax liabilities.

After retaining the services of a consultant and being told that the donation of a conservation easement on Sherwood Farm could generate a federal deduction of roughly $6.7 million and a state income tax credit of roughly $3.2 million, Mr. Lewis decided to donate an easement. He also contracted with a Virginia limited liability limited partnership (Virginia Conservation) to help him sell or “allocate” the excess state tax credit generated by the donation (i.e., the amount of credit in excess of what Mr. Lewis could use to offset his own state income tax liability). The Tax Court described Virginia Conservation’s business activities as including “the acquisition and syndication of Virginia tax credits.” The consultant was paid a fee of $356,759 for its services relating to the easement donation and credit transfer transaction.

Disguised Sale

In December 2005, SWF donated a conservation easement on Sherwood Farm to the Public Recreational Facilities Authority of Albemarle County, Virginia. SWF obtained an appraisal estimating the value of the easement to be $7,398,333 and reported that amount as a charitable contribution on its 2005 federal partnership return.

In the same month, Virginia Conservation contributed approximately $1.8 million to SWF in exchange for a 1% interest, leaving Mr. Lewis with a 99% interest in SWF owned through his S-Corporation. While SWF’s operating agreement allocated partnership profits, losses, and net cash flow to the two partners in proportion to their respective percentage interests, it also provided that most of the state income tax credit generated by the easement donation would be allocated to Virginia Conservation. SWF treated this transaction as a $1.8 million capital contribution by its 1% partner (Virginia Conservation) followed by an “allocation” of roughly 92% of the state tax credit to that partner.

In holding that the alleged capital contribution transaction was, in large part, a disguised sale, the Tax Court relied on the 4th Circuit’s decision in Virginia Historic Tax Credit Fund 2001 LP v. Comm'r, 639 F.3d 129 (4th Cir. 2011), which the Tax Court found to be “squarely on point.” The Tax Court also relied on its earlier decision in Route 231, LLC v. Comm'r, T.C. Memo. 2014-30, which involved a nearly identical transaction (the same 1% partner), and was also found to be a disguised sale.

In explaining its holding, the Tax Court noted that IRC § 707 “prevents use of the partnership provisions to render nontaxable what would in substance have been a taxable exchange if it had not been ‘run through’ the partnership.” The substance of a transaction governs rather than its form, and transfers made between a partnership and a partner within a two-year period are “presumed to be a sale…unless the facts and circumstances clearly establish that the transfers do not constitute a sale.”

In applying the tests under IRC § 707, the Tax Court determined, among other things, that Virginia Conservation would not have transferred money to SWF “but for” SWF’s corresponding transfer of a portion of the tax credit to Virginia Conservation. In addition, SWF’s transfer of a portion of the credit to Virginia Conservation was not dependent upon the entrepreneurial risks associated with SWF’s partnership operations. Rather, Virginia Conservation was promised a legally enforceable, fixed rate of return in the form of a portion of the tax credit in exchange for its alleged capital contribution and it was shielded from suffering any loss through an indemnity clause. There also was no indication that Virginia Conservation reviewed SWF’s financial records pertaining to its farming business and cattle breeding operation; Virginia Conservation was solely interested in the credit transaction.

The timing of SWF’s receipt of the proceeds from the disguised sale was also at issue. SWF argued that the proceeds should be treated as income received in 2006. The Tax Court disagreed, finding that the proceeds (which remained in escrow until 2006) were irrevocably set aside for SWF’s sole benefit in 2005 and only ministerial tasks remained before distribution. Accordingly, pursuant to the “economic benefit theory,” the proceeds were income to SWF in 2005.

Easement Value

Mr. Lewis purchased Sherwood Farm through his S-Corporation in May 2001 for $3.45 million. Four years and seven months later, in December of 2005, he donated an easement on the farm and claimed a federal charitable income tax deduction of $7,398,333 based on an appraisal that indicated that the farm had more than tripled in value to $11,446,233. The IRS challenged SWF's claimed value for the easement.

At trial, SWF and the IRS each offered the report and testimony of a valuation expert. After careful review, the Tax Court found the report and testimony of SWF’s expert to be more credible and reliable than those of the IRS’s expert. The court found the IRS expert’s report and testimony to be “burdened by multiple errors and inconsistencies.”

SWF’s expert at trial concluded that the value of the easement was $7,350,000, or the difference between (i) his estimated before-easement value of $10,460,000 and (ii) his estimated after-easement value of $3,040,000 and a $70,000 “enhancement adjustment.” The enhancement adjustment was the amount by which he estimated that a 65.9-acre parcel located near Sherwood Farm that Mr. Lewis also owned was enhanced in value as a result of the easement donation.

The Tax Court agreed with SWF's expert and concluded that the value of the easement was $7,350,000, or only $48,333 less than what SWF originally claimed. The Tax Court thus reduced SWF's originally claimed value by less than 1%.

Technically, the value of the easement based on SWF’s expert’s report was $7,420,000 (the difference between his estimated before and after easement values). Adjustments for enhancement to nearby noncontiguous parcels owned by the donor do not reduce the value of the easement—they reduce the amount of the deduction. See Treas. Reg. § 1.170A-14(h)(3)(i) (“If the granting of a perpetual conservation restriction…has the effect of increasing the value of any other [noncontiguous] property owned by the donor…, the amount of the deduction…shall be reduced by the amount of the increase in the value of the other property.”) (emphasis added).

Conclusion

The taxpayer has appealed the Tax Court’s holding in Route 231, LLC to the 4th Circuit. Whether SWF will do the same with regard to the disguised sale holding in this case remains to be seen.

Nancy A. McLaughlin, Robert W. Swenson Professor of Law, University of Utah S.J. Quinney College of Law